In late 2000, Lucent announced that revenues would be adjusted downwards by $679 million as a result of revenue recognition problems.

Yet the firms market capitalization plummeted by $24.7 billion. Why do you think the market reacted so negatively to Lucents announcement of the problems? In product development it had failed to foresee the rapid switch to fibre-optic networks, enabling competitors such a Nortel Networks Inc. to capture market share. As a result, at the end of 2000 the company reported earnings declines for 2 consecutive quarters. This provided incentives for Lucent to manage its profit and recognise revenue that was not yet realised. By 2000, the technology boom had lost momentum, leading to excess capacity, increased price competition and decrease in demand for internet networking equipment, software and services. This provided further incentive for Lucent to manipulate profit figures as industry wide sales were decreasing, but in an effort to maintain growing revenue figures, Lucent manipulated revenue figures through premature revenue recognition and (refer below) They boosted sales through vendor-financing arrangements, in which Lucent would lend customers the money to buy equipment and sometimes install it too. The sales teams had verbally offered credits to customers for use at a later date to help secure fourth quarter sales. Revenue for Lucent was steadily increasing until June 2000, when it dropped down by 2000 and then a further 4000 (millions) in September compared to Cisco and Juniper and Nortel who all made steady increases in revenue over the June-Dec period. This shows that it was not industry wide shortcomings but a result of poor management and internal control. To attract customers, Lucent provided medium to long-term financing and financing guarantees to its customers. The extended credit to customers will affect the receivable accounts and might give rise to allowance for bad debts and bad debts expense. Therefore, recognized revenue will be boosted in this period by putting next years profit at risk Sacking of CEO, and then drops in revenue demonstrates that the previous CEO allowed the manipulation to occur damages reputation and credibility. Lucent tried to sell its equipment and recognizing revenue before it was passed to the customer. This raised a suspicion that Lucent tried to boost its profit.

What financial statement adjustments will Lucent have to make to correct the revenue recognition problems announced in late 2000? Credits to customers for use at a later date to help source fourth quarter sales would not meet revenue recognition criteria and thus must be reduced. The provisions for doubtful debt should be increased to inform the stakeholders about the potential failure to collect cash in the future. Therefore, both operating profit on the income statement and the total assets in the balance sheet should be reduced. Equipment selling Asset balance will decrease - Accounts Receivable down, depreciation expense up, profit down Recognition of liabilities through unearned revenue rather than recognising revenue prematurely

How would you judge whether a firm is likely to face revenue recognition problems? When a company is facing underperformance for several quarters, there is a larger incentive for them to manipulate revenue figures and record them prematurely. The provision for doubtful debts suddenly increase significantly as they are attempting to provide more leeway for debtors to repay debts When there is a sudden gap between revenue in one period relating to the next period

Assess whether any of Lucents competitors are likely to face revenue recognition problems in the coming quarters Using the analysis of percentage allowed for doubtful debts, Nortel would appear to be the most likely to face revenue recognition problems in future as their percentage of allowances per accounts receivable is 4% compared to Ciscos 1.9% and Junipers 2% However, by looking at revenue figures over the given period, Junipers revenue has increased significantly since Sept 98. Revenue also increased 1.5 times from Sept 2000 to December 2000 despite the loss of technology boom momentum experienced at the end of 2000.